The following post is written by Brian So, an insurance advisor and blogger at briansoinsurance.com.
Introduction to MLPs
Master Limited Partnerships, or MLPs, are publicly traded investment partnerships based in the U.S. They combine the liquidity of a publicly traded company with the tax efficiency of limited partnerships. The business is structured with a general partner in charge of operations, and limited partners providing the capital. Units of the partnership represent the limited partner’s stake in the company, and are traded publicly on stock exchanges.
In order to qualify as a MLP, the partnership must derive at least 90% of their income from the energy sector, primarily oil and gas. Much like the energy income trusts, that we used to have in Canada before the tax loophole was closed in 2011, MLPs are allowed to pass their income to their unitholders without paying much tax. This distribution means that unitholders are responsible for paying taxes at their own marginal tax rates. It’s also the main reason MLPs are such a popular business structure, since the MLP is off the hook for taxes on their profit. Compared to dividends, where they are taxed once at the corporation level and again on the personal level, you can see the benefit of MLP taxation.
Another benefit from MLP is the ability to defer tax. Distributions from a MLP are split into return of capital and income. The return of capital reduces your adjusted cost base (ACB) while the income is taxable at your marginal tax rate. With the majority of distribution being return of capital, an investor only has a small amount of tax to pay on the income portion. The reduction of the investor’s ACB means that he can defer paying tax until he disposes of the units or his ACB is reduced to zero.
Canadians holding MLPs in non-registered accounts
In an earlier post I made here, I mentioned that Canadians receiving U.S. dividends are subject to a 15% withholding tax. In non-registered accounts, the tax withheld can be claimed back via the foreign tax credit when you file your tax return. The end result is that you end up with 100% of the dividend. Distributions from a MLP are subject to similar rules. You’ll also be charged a withholding tax which could be claimed back with the foreign tax credit. You can recover the full amount charged, which is 35% in the case of MLP distributions.
Canadians holding MLPs in registered accounts
You may recall from my earlier post that the withholding tax is waived if you hold the U.S. stock in a RRSP. Since you don’t receive a T5 for investments held in a RRSP, there is no way for you to claim the foreign tax credit. It would be unfair to penalize investors who were saving for retirement by means of dividend paying stocks, without allowing them to recover the withholding tax. Therefore, in the tax treaty between Canada and U.S., withholding tax from dividends is waived for retirement savings accounts, such as the RRSP.
Since the TFSA is used for many things besides a retirement savings account, withholding tax is not waived. Consequently, you must pay the withholding tax, which is unrecoverable.
The same tax treaty covering U.S. dividend paying stocks does not include MLPs. This means that distributions from a MLP will be charged the whole 35% withholding tax in both a RRSP and TFSA. This amount is unrecoverable, so think twice before putting a MLP in a registered account.
If you are intrigued by the high yield and growth of MLPs, as well as their tax benefits, consider holding them in non-registered accounts. While this post provides general information on situations involving taxation of MLPs, it is not tailored to your circumstances. Please seek a tax professional regarding your tax obligations.
Brian So, CFP, CHS, is an insurance broker and blogger at briansoinsurance.com . Follow him on Twitter for his musings on life insurance and why the Vancouver Canucks will win the Stanley Cup next season (Seriously).